At some point in your life you may find yourself in the happy dilemma of having a large chunk of cash to invest. An inheritance perhaps, or maybe money from the sale of another asset. Whatever the source, investing it all at once will seem a scary thing as we discussed in Part XVIII.
If the market is in one of its raging bull phases and setting new records each day, it will seem wildly overpriced. If it is plunging, you’ll be afraid to invest not knowing how much further it will fall. You risk wringing your hands waiting for some clarity and, as you should know by now, that will never come.
The most commonly recommended solution is to “dollar cost average” (DCA) your way slowly into the market. The idea being, should the market tank, you will have spared yourself some pain. I’m not a fan of this strategy and will explain why shortly, but first let’s look at exactly what dollar cost averaging is.
When you dollar cost average into an investment you take your chunk of money, divide it into equal parts and then invest those parts at specific times over an extended period.
Let’s suppose you have $120,000 and you want to invest in VTSAX, the total stock market index fund we’ve been discussing throughout this Series. Now having read this far in it, you know the market is volatile. It can and sometimes does plunge dramatically. And you know, therefore, this could happen the day after you invest your $120,000. While unlikely, that would make for a very miserable day indeed. So instead of investing all at once you decide to DCA and thus eliminate this risk. Here’s how it works.
First you select a time period over which to deploy your $120,000, let’s say the next 12 months. Then you divide your money by 12 and each month you invest $10,000. That way, if the market plunges right after your first investment you’ll have 11 more investing periods that might perform better. Sounds great, right?
This does eliminate the risk of investing all at once, but the problem is that it only works as long as the market drops and the average cost of your shares over the 12 month investing period remains on average below the cost of the shares the day you started. Should the market rise, you’ll come out behind. You are, basically, trading one risk (the market drops after you buy) with another (the market continues to rise while you DCA meaning you’ll pay more for your shares). So which risk is more likely?
Assuming you were paying attention while reading the earlier Series posts, you know that the market always goes up but it is a wild ride and no one can predict what it will do in any given day, week, month or year. The other thing to know is that it goes up more often than it goes down. Consider that between 1970 and 2013, the market was up 33 out of 43 years. That’s 77% of the time.
At this point you are probably beginning to see why I’m not a DCA fan, but let’s list the reasons anyway:
- By dollar cost averaging you are betting that the market will drop, saving yourself some pain. For any given year the odds of this happening are only ~23%.
- But the market is about 77% more likely to rise, in which case you will have spared yourself some gain. With each new invested portion you’ll be paying more for your shares.
- When you DCA you are basically saying the market is too high to invest all at once. In other words, you have strayed into the murky world of market timing. Which, as we’ve discussed before, is a loser’s game.
- DCA alters your asset allocation strategy. Suppose you had $100,000 and your allocation was 50% stocks, 25% bonds and 25% real estate equity in an investment house. Now you decide to sell the house, planning to invest the $25,000 from it into your stocks for a 75/25 stock/bond allocation. If you decide to DCA, your real allocation in the beginning is not your 75/25 target. It is 50/25/25: 50% stocks, 25% bonds and 25% in cash. You are holding an outsized allocation of cash sitting on the sideline waiting to be deployed. That’s OK if that’s your allocation strategy. If it’s not you need to understand that, in choosing to DCA, you’ve changed your allocation in a deep and fundamental way.
- Unlike stocks, the cash you have waiting to invest is not earning dividends. For example, VTSAX pays ~2% in dividends.
- Your cash should earn some interest, but with rates being under 1% and inflation running at around 3%, each year your cash effectively loses ~2%. Combined with the dividends not collected (Point #5) that’s a 4% drag on your returns.
- When choosing to DCA, you must also chose the time horizon. Since the market tends to rise over time, if you chose a long horizon (say, over a year) you increase the risk of paying more for your shares while you are investing. If you chose a shorter period of time, you reduce the value of using DCA in the first place.
- Finally, once you reach the end of your DCA period and are fully invested, you run the same risk of the market plunging the day after you are done.
What to do instead?
Well, if you’ve followed the strategies outlined in Part VI, you already know whether you are in the wealth accumulation or wealth preservation phase.
If you are in the wealth accumulation phase you are aggressively investing a large percentage of your income. In a sense, this regular investing from your monthly income is a form of unavoidable dollar cost averaging and it does serve to smooth the ride. The big difference is you’ll be doing it for many years or even decades to come.
But you are putting your money to work as soon as you get it in order to have it working for you as long as possible. I’d do the same with any lump sum that came my way.
If you are in the wealth preservation stage, you have an asset allocation that includes bonds to smooth the ride. In this case, invest your lump sum according to your allocation and let that allocation mitigate the risk.
If you are just too nervous to follow this advice and the thought of the market dropping shortly after you invest your money will keep you up at night, go ahead and DCA. It won’t be the end of the world.
But it will also mean that you’ve adjusted your investing to your psychology rather than the other way around.
Most people are effectively using DCA as they contribute to their tax-advantaged accounts such as 401Ks during the year. But if the disadvantages to DCA described here resonate with you, our friend The Mad Fientist offers a strategy to eliminate it: Front Loading. As you’ll read, there are other advantages to this approach beyond avoiding DCA.
Mike & Lauren explore the emotional side of DCA in this video: What is your emotional threshold?